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Asset allocation: Our convictions

We have repeatedly mentioned how financial markets have tended to overestimate the risks of European elections, underestimate the fears of the Brexit and overestimate hopes on Trump’s economic policy. We can even say that this theme has strongly guided our asset allocation choices and our macro-hedging strategies. Well, here we are...

French elections reassure

Market relief was significant, in an environment in which, nevertheless, the negative scenarios were not really ‘predicted’, probably proof of relative serenity in the run-up to the elections, or a sharp underweight on France or a wait-andsee attitude. There was no resolutely hostile stance, despite the race leading the drills of Marine Le Pen, then the disappointments of François Fillon, the rise of Jean-Luc Mélenchon, and finally the fears of a scenario Le Pen - Mélenchon in the second round. Overall, the impact on the French and European markets has been limited. But on several points, including the elimination of extreme risk (a duel between Le Pen and J.-L. Mélenchon, a top score of M. Le Pen in the first round in particular), and the elimination of European systemic risk Frexit, to summarize), the first round of the elections has produced a long-lasting trend. As in Spain, Italy, Austria and the Netherlands, there will probably not be a populist party in power in France. The difficulty will be for Macron, if elected, to win a majority in the next parliamentary elections (11 and 18 June), or he will have to compose a coalition government with allies that can come from left and right. The stakes are great, and wait until mid-June for final answers.

For now, because of the disappearance of extreme risks to Europe in particular, a return to French fundamentals is needed, and this will make it possible to highlight a tangible reality:

An improving economic situation,

An investment that starts up again,

One of the best performing banking sector in EMU countries,

Significant growth in credit to SMEs,

Leading indicators on the rise,

Better profit prospects,

A euro that depreciated in real terms following the strong appreciation of emerging currencies since the beginning of the year,

A low-rate environment,

Budgetary room for manoeuvre resulting from the sharp reduction in debt service (low interest rates)...

Trump disappoints ... and it’s probably not over

Trump still delivers strong speeches and comments, of course, but with a quite limited ability to carry out its “reforms”. After the setback of the removal of the Obamacare, everyone was waiting for tax reform. It took time, because the positions of Congress are firm. Trump nevertheless announced a few days ago a historic cut in taxes, the largest since the 1980s (Ronald Reagan). Presented as self-funded, it still needs to be approved by Congress. This will not be easy because, if it is self-financed in D. Trump’s and its Administration’ mind (the resulting growth will make it possible not to deteriorate public finances), it is not funded in the economic sense, and according to the references of Congress: an expansionist measure has to find concomitant financing (for example, a reduction in spending) and not a delayed financing. Trump’s dialectic is close to that of R. Reagan, but it is no longer usable today: the starting point of Trump’s mandate has nothing to do, in terms of deficits and debts, with the starting point of R. Reagan, while the main measures favour the most affluent businesses and incomes, which is not to the liking of very many delegates, who have already made it known:

Corporate tax: a reduction of 35% (the highest rate among OECD countries) to 15%. It should be noted that, given the various deductions and amenities, the full rate of 35% is rarely applied. Despite this, it is an important measure;

Income tax: reduction of the number of tranches from 7 to 3 (from 10% to 35% maximum), reduction of the maximum rate from 39.6% to 35% (applicable to incomes above 470k dollars), elimination of a 3.8% tax financing the Obamacare (currently applied to incomes above 250k dollars), removing practically all possibilities of tax deductions in order to simplify;

Inheritance tax: lower taxation on the transfer of wealth when it is above a certain threshold.

3 key words for Trump’s tax reform:

Improving the competitiveness of enterprises through a more effectve tax system;

We can adhere to such principles, but we see that aid to the most disadvantaged households is not at the centre of the reform, on the contrary. Will these reforms be adopted by Congress as it stands? Quite frankly, we can doubt it. Of course, the risk is to have a great disappointment on the “repricing” of growth, the victim of which would be the American stock market, whose valuation is already deemed excessive.

The Brexit will be a difficult exercise for the UK

The leaders of the 27 European countries (EU without the British) have recently unanimously adopted the main principles of the forthcoming negotiations with the United Kingdom on Brexit. This may seem surprising given the past divisions, but the special Brexit summit of April 29 showed the unity of the Union. “Directions adopted unanimously. The firm and fair mandate of the EU-27 for talks on the Brexit is ready, “according to D. Tusk. “We are ready and we are united,” said the head of European negotiators, Michel Barnier, who also excluded any trade negotiations as long as “significant progress” has not been recorded on key issues.

The main EU principles on Brexit

According to the statements of the EU 27 officials, the most important principles would be:

Divorce before any commercial negotiation. The EU-27 first want to settle divorce issues before negotiating a trade agreement. It is impossible to resolve these two issues in less than two years (it takes an average of 7 to 10 years for a commercial agreement). The United Kingdom would have liked to see these two issues resolved in parallel, but this will not be the case.

The issue of the “future relationship” can only be addressed if there is “sufficient progress” on the “exit” agreement. For the Prime Minister of Luxembourg, Xavier Bettel, “the British are no longer in our family, but they remain our neighbours and as such we must respect ourselves.”

No à la carte privileges. The United Kingdom, freed from its obligations to the EU, will not have the same rights and benefi ts as an EU Member State.

Avoid chaos. The EU wants an “orderly exit” from the UK to avoid “uncertainties” and “disruptions”. The EU-27 want the UK to remain a “close partner”.

Citizens’ rights. The EU-27 want to settle the fate of the three million EU citizens living in the UK and the one million British people residing in the EU. It deals with the right of residence, the recognition of diplomas, the right to employment, the right to pensions, the right to social protection ....

The divorce bill. The UK will have to pay all its financial commitments (participation in the various European programs and funds, contribution to the budget ...). The Europeans estimate the UK’s overall bill at around 60 billion euros. This will be a tricky issue.

North Ireland. At the request of Dublin, the other 26 EU countries accepted the idea of automatic accession of Northern Ireland to the EU, once the Brexit had been finalized, but only in the context of a 1998-bill reunification of the island.

Gibraltar. Resolving the conflict between the UK and Spain is another EU priority. The territory has been under British administration since 1713, but is regularly claimed by Madrid. The EU- 27 have already affirmed that no agreement on a future relationship between the European Union and the United Kingdom will apply to Gibraltar without an agreement between Madrid and London.

On his arrival in Brussels, François Hollande had warned London that the Brexit “would necessarily have a cost for the United Kingdom”. “Europe will defend its interests”.

Wolfgang Schäuble, recalled that the United Kingdom would not benefit from its divorce with the EU once the negotiations on the Brexit had been completed. “There is no” free lunch “. The British must know it “, Schäuble said. “We do not want to weaken the UK. But we do not want the rest of Europe to be weakened. The UK, after leaving the EU, should not get benefits that other countries would not have “. Meanwhile, Angela Merkel recalled that the British must not “make illusions”.

What are the next steps?

22 May 2017: The separation directives should be adopted by the 27 EU countries;

8 June: date of the British general elections, called by Theresa May for more solid political support;

9 June: Europeans want to start negotiations with the UK.

Brexit: would the English begin to regret their vote?

On 27 April, the daily “The Times” published the first poll (YouGov survey) which shows that a majority of Britons regret the outcome of the 23 June referendum in favour of an EU exit. To the question “Looking back, do you think that the UK was right or wrong to vote for the exit of the EU? “, 45% of respondents said they were sorry for the vote in favour of the Brexit, 43% agreed, and 12% had trouble deciding. Proof of the strong cleavage on the subject, the poll also revealed that 85% of those who voted for the Brexit were satisfied with their choice and that 89% of pro-EU members still thought that the referendum should have not resulted in a rejection of the Brexit.

What else should be retained in the past month?

The French elections and Trump’s fiscal plan were undoubtedly the most important events of recent weeks, but our attention was drawn to other significant elements:

The “global reflation” scenario remains dominant: many institutions are revising their GDP growth forecasts, including international organizations;

Global trade is recovering, especially in Asia: it is known that since the financial crisis and even more since 2011, world trade is no longer a global growth engine, but in some areas, including Asia, growth still benefits from trade;

Growth in the euro area is revised upwards, thanks in particular to improved credit and investment. PMIs are in the Eurozone at their peak for the past 7 years, and are even currently consistent with GDP growth above our expectations. All this bodes well for attractive projections of profits and stock markets, all the more so as rates remain low: inflation under control, elimination of the risk premium on Frexit, reduction of the systemic risk linked to the European elections, doubts about Trump’s ability to “boost” growth;

Inflation remains under control, both in the Eurozone and in the United States, although the trend is somewhat positive;

Chinese growth sees investment become a growth engine again, but private debt is still growing (see article 3 of this edition);

Economic indicators for emerging economies have probably never been stronger overall over the past five years;

The United Kingdom has not (yet?) entered the Brexit-related disorder, but growth is slowing. It remains certainly higher than the initial expectations, but negative signs are emerging, notably on the consumer side. As a result, the BoE is far from any monetary tightening.

What should we look at now?

This return to the fundamentals of the French economy must not make us forget the international environment:

The possible disappointment in the rate of growth of the US economy is an asset for markets such as Europe or emerging countries;

The Fed has started a more pronounced tightening pace, but this will depend on the rate of growth and the Trump government’s ability to use the fiscal and tax weapon: the less room for Trump’s manoeuvre and the less the Fed Will be able to pursue its policy of raising rates;

The possible disappointment with “Trumpflation”: tax and fiscal measures were delayed in coming, proof that the Congress and the Administration were struggling to find common ground. The measures announced recently will have to be validated by the Congress … unlikely before year-end;

As for the ECB, it did not have to counter any move of defiance related to the French elections, which is rather good sign. The ECB maintains ultralow rates and a generous asset purchase program (it buys more than twice the net emissions of the zone), but the debate over the durability of these devices will re-surface during the year.

Amundi’s asset allocation is broadly unchanged:

Our preference for European equities is maintained: the economic situation is better, as well as the prospects for profits. The depreciation of the euro against emerging currencies is also an asset for future profits. The ebb and flow of the specific risk France (elections) and the systemic risk Europe (Frexit) should restore interest in the zone.

Long European bonds depend of course on economic activity indicators (rather good at the moment, including in Europe) and inflation (rather slightly upwards, but core inflation remains below 1%). They also depend on the policy of D. Trump (fiscal and tax policy in particular), and on monetary policies (rather accommodative). All in all, it seems legitimate not to be long. Do not bet on strong long rate rises in the eurozone, but do not expect strong declines either.

We remain overweight stocks vs. sovereign bonds, especially because the equilibrium rate is lower in Europe than elsewhere ...

Risk-taking on the debts of the periphery of the euro area and the semi-core (France, the Netherlands in particular) can be kept in the current environment.

We expect better levels to return to the US Treasuries market. The Fed continues to raise its rates, and the level of bond yields is currently at the bottom of its “range”. US sovereign bonds are of particular interest for the carry they offer, but also for the natural qualities of macro-hedging in the event of difficulties in the emerging world, or in Europe. This is less interesting now.

We have gradually returned to the emerging markets, and we are pursuing this attitude, because in the medium term, these markets retain many attractions. Attractive valuations, often undervalued currencies, large underweights in portfolios, potentially high capital flows ... all of which justify staying positive.

We remain very cautious towards the GBP. As we have pointed out several times, Brexit represents an asymmetric risk and the most natural and simplest expression of risk (declared or feared) will be on sterling. The weakness of the demand is triggered, it seems to us.

Currencies like the Swedish and Norwegian crowns remain interesting: they appear to us to be significantly undervalued at this stage, with monetary policies very (or even too) accommodative.

Macro-hedging strategies are reduced. The global geopolitical context, diplomatic tensions between the United States and some major countries (China at the forefront) and the political context in Europe justify some protection measures (US Treasuries, volatility, put options on equity markets, cash In USD and inflation-linked bonds). Reduce however the hedging positions against European risks, i.e. long volatility positions, long USD, long Japanese Yen and long US Treasuries.